Carbon Cap and Trade—The Balancing Act By Patrick Reames

The first attempt to bring forth cap and trade legislation to limit greenhouse gas (GHG) emissions died earlier this month when the Lieberman-Warner-Boxer Climate Change Bill failed in the Senate on procedural grounds. While the bill received more support than previous attempts at climate legislation, much of that support was more symbolic that concrete. In fact, ten of the Democrats who voted to move the bill to a full Senate vote (which ultimately never took place) followed-up, post failure, with a letter to the leadership of the party stating that they would have not have ultimately voted to pass the bill in its proposed form and their future support of any GHG legislation would be predicated upon it meeting several key points, which they detailed as:

• Contain costs and prevent harm to the US economy,
• Invest aggressively in new technologies and deployment of existing technologies,
• Treat states equitably,
• Protect America's working families,
• Protect U.S. manufacturing jobs and strengthen international competitiveness,
• Fully recognize agriculture and forestry's role,
• Clarify federal/state authority, and
• Provide accountability for consumer dollars

And There's the Rub
The issues outlined by the Democratic Senators (the party that is generally deemed to be more supportive of environmental legislation) highlight the critical issues facing any future cap and trade legislation. Despite acknowledging a strong desire to do what they feel is necessary to limit CO2 emissions, these legislators, and many more, recognize that if cap and trade legislation is implemented without measured consideration and extreme care, the U.S. economy could be seriously damaged, with every American affected in ways that most consider unacceptable.

Part of the political problem of enacting a cap and trade scheme (which will be one of, if not the largest, federal program ever enacted) is no real environmental benefit will accrue for many years, as even the most optimistic projections of any plan note that these programs are being enacted in order to stave off the most serious climate effects decades from now. However, the costs will be felt by consumers almost immediately as energy costs will reflect the immediate and anticipated costs of compliance. Utilities are the largest emitters of greenhouse gases in the United States and will be the first targets of legislation. Customers of the largest coal fueled generators, like AEP, Southern and Duke, will feel the pain more than others. There is no way to isolate the consumer from the cost of CO2 emissions reductions.

Some cap and trade schemes being contemplated, like the Lieberman-Warner-Boxer Bill, are based around the auction of the initial emissions permits, or certificates, by the Federal government to the newly-regulated industries. The proceeds from this auction could then be used in various ways to help offset the effects of the program. However, the proceeds of an auction would be a very real cost to industry and would be fully reflected in higher costs for the customers of those effected industries.

Even if the certificates were awarded freely to industry instead of being auctioned, consumers would still be impacted. As the Congressional Budget Office noted in their report, "Trade-Offs in Allocating Allowances for CO2 Emissions" released last year, a CO2 allowance or certificate, even if provided at no cost to a producer, would be treated akin to an asset, an asset that allows that producer to continue to operate while producing CO2. As that allowance is "used up" in the production process, the value of that allowance will be passed to the consumer—at a cost equivalent to replacing that allowance or acquiring an equal amount of carbon reduction technology.

The Senators in their letter note that the Lieberman-Warner-Boxer Bill would have generated up to $7 trillion dollars for the Federal government, the cost of which would be passed on to consumers in the form of higher retail prices for everything from gasoline to food. And this figure, which represents more than $23,000 for every man, woman, and child in the United States, may only be the starting point. The estimates of the effect of a cap and trade system assume technologies will advance sufficiently to allow economically feasible incremental reductions in CO2 emissions to targeted levels; should those technologies—like carbon capture and sequestration (CCS) and clean coal—not pan out, the ultimate costs could be so high as to force abandonment of the program—leaving a big smoking hole in the economy without any of the desired effects.
One of the cornerstones for supporters of greenhouse gas emission reduction legislation is that job losses that result from the impacts to manufacturing and production will be offset, at least partially, by new "green jobs"-those that would potentially materialize from deploying new carbon reduction technologies. These employment offsets have been included in most projections of costs of GHG reduction, and again, should they not materialize, the costs could be even greater still.

Un-leveling the Playing Field
As the Senators' point that any legislation passed must protect U.S. manufacturing implies, a cap and trade program can have very serious ramifications for U.S.-based industry, including producers of oil, gas, refined products, chemicals, metals, coal, and every conceivable consumer good. Each of these industries is going to see the costs of their U.S.-based facilities increase. There is no way around it. If every competing manufacturer around the globe faced the same increases, there would be no concern about competitiveness. However, China, the country that has become the primary base for outsourced manufacturing, and others like India, have clearly indicated that they have no intention to implement any CO2 emissions rules, and certainly none that come anywhere close to being as stringent as those being contemplated in the United States. Given that reality, U.S. industry, particularly manufacturing, will be at a disadvantage against global competitors not faced with similar carbon reduction schemes and will undoubtedly demand some form of trade legislation/tariffs that reflect that disadvantage. If they don't receive some type of assistance, many of these manufacturers may seek to relocate to less costly jurisdictions in order to maintain their competiveness, with the result being increased job loss in the United States.

Additionally and again noted in the Senators' letter, there will be considerable thought necessary to balance the rights of the states against the rights of the Federal government. Any Federal cap and trade legislation will need to ensure that all states are treated equitably. However, as industry is not distributed evenly across the states, those which contain a greater concentration of heavy industry may be more significantly impacted by GHG legislation and will demand some form of relief from its effects, while other states which have already begun regulating carbon emissions, such as California and Massachusetts, will demand an acknowledgement of those efforts. Clearly, the issue of states' rights will come to the forefront in legislators argue the construction of any program.

The European Experience
Europe, which began regulation of greenhouse gas emissions with a cap and trade program in 2005, can offer some insights into the potential issues if the programs are not properly implemented. Under the first phase of the EU Emissions Trading Scheme (ETS), emissions certificates were awarded by the individual national governments to the effected industries, generally at no cost to those industries. It was up to the governments to determine the number of permits to award to any individual facility or company within their jurisdiction. When trading of the certificates opened, the certificate prices trended steadily upward peaking at more than 30 Euros in early 2006. However, within months it become clear to the market that the certificates were over allocated, meaning that little or no emissions reductions were necessary beyond "business as usual" in order to meet lax reduction standards. Subsequently, the value of the certificates fell to fractions of a Euro (less than 10 U.S. cents) as the market dried up. Ultimately, the EU ETS Phase 1 ended with emissions trading virtually dead and, according to the latest available figures, an increase in European GHG emissions in 2006 and 2007 of more than 1 percent over 2005 levels.

Despite the failure of the plan to reduce emissions, many are touting the EU ETS as a success. According to a report issued by the Massachusetts Institute of Technology (and released in support of the Senate's efforts to pass the Lieberman-Warner-Boxer Bill), the EU plan created the infrastructure for achieving reductions and had limited macroeconomic impacts. The economic impacts that have been noted were significantly higher regional electricity costs in the first year and half (corresponding to the period prior to the crash in the ETS market) and some loss of business to non-EU companies, particularly in the steel industry (and again, this is against a backdrop of no real reduction in CO2 emissions).

Phase 2 of the EU plan takes effect this year and runs through 2012. This latest iteration makes some significant adjustments, including a greater percentage of certificates auctioned, more centralized authority (less national control) and a more aggressive cap on emissions. It is this latest phase that will provide the best test of the program's effectiveness in reducing carbon emissions and its effects on the economies of the EU, in particular heavy industry and consumer costs for fuels and electricity.

What Do the Presidential Candidates Say?
Both of the major party presidential candidates, Barak Obama and John McCain, have made very unambiguous statements that they would not only support such legislation, but would in fact push for its adoption.

However, saying they both support cap and trade is one thing. As with most everything in life, the devil is in the details—and unfortunately, a lot of the details are missing from both platforms. In anticipating the impacts of a cap and trade systems, several key parameters need to be understood, including: how will the caps be established and how will they be phased in; how will be credits be allocated—via auction, award, or a mix; if auctioned, how will be proceeds of the auction be used—will they be used to offset economic losses; will offsets be allowed; will there be a bail-out provision should the reductions not occur without serious or catastrophic economic damage? A review of their respective positions (as posted on their campaign websites) while light on details, does reveal some important differences
:
The Obama Plan
• Reduce Carbon Emissions 80 Percent below 1990 levels by 2050 - no detail on intermediate targeted reductions
• 100 percent auction of certificates with "some of the revenue generated by auctioning allowances will be used to support the development of clean energy, to invest in energy efficiency improvements, and to address transition costs, including helping American workers affected by this economic transition.
• Unclear as to whether to allow offsets, but does say he wants to confront deforestation and promote natural carbon sequestration, such as that provided by agriculture.

The McCain Plan
• Reduce Carbon Emissions 60 percent below 1990 levels by 2050, with intermediate targets at 2012, 2020 and 2030
• A combination of allowance awards and auctions. A portion of the proceeds of these auctions will be used to support a diversified portfolio of research and commercialization challenges, ranging from carbon capture and sequestration, to nuclear power, to battery development. Funds will also be used to provide financial backing for a Green Innovation Financing and Transfer (GIFT) to facilitate commercialization.
• Allowance of offsets in lieu of emissions reductions

Senator Obama's plan, being the more ambitious of the two, will certainly be the more costly. Setting aside potential differences in the areas of offsets and other details, experience and a review of available technologies tells us that the cost of the incremental 20 percent reduction proposed by Obama's plan will result in total program costs far beyond those envisioned under the McCain plan. Carbon reduction is an exercise in diminishing returns-each incremental reduction in emissions will be substantially more difficult and costly to achieve than that which preceded it.

Managing Risks of Cap and Trade
Clearly, after the November elections, there is going to be a renewed push toward cap and trade legislation. Should some form of cap and trade be implemented, the ability of industry to manage their risks associated with that market may mean the difference between corporate life and death.
I spoke to Dr. Mark Earthey, Managing Director of Lacima Group - Europe1, and an authority on the European scheme, about the implications for risk managers as they anticipate potential legislation. According to Dr. Earthey, "Political and regulatory risk should be high up U.S. risk managers' agendas as they ponder the ramifications of a scheme similar to that of Europe." He listed some of these regulatory issues that risk managers will need to contend with as they anticipate what may occur:

• Changes to the global “Big Picture”, such as a “son of Kyoto” post-2012, and the implications should the U.S. program have linkages with those of the EU and others
• At the national strategic level, what will happen if anticipated emissions reductions don't occur or the costs associated with the targeted reductions become economically unacceptable? Will the market be subject to a “helping hand”, i.e., direct intervention via rules changes?
• At the tactical level, random minor adjustments by the technical authorities to emissions calculations methodologies may change underlying physical liabilities of some sectors.
• Changing/imposing project credit import quotas (e.g., from the EU ETS or CDM) impacts the domestic allowance supply-demand balance.
• Clumsy or negligent release of market-sensitive data from a relevant authority such as happened in Europe, leading to the precipitous drop in value for emissions certificates.
• Introduction of new sectors, and uncertainty over timing & amount of liability due to delaying tactics (lobbying) by that sector.
• Arguments over the basis & consistency of allowance allocations.
o by sector
o by state
• New legislation or regulatory rule making in related areas, such as renewable energy sources, energy efficiency, CCS.

According to Dr. Earthey, "All these regulatory risks will impact carbon price volatility to a greater or lesser extent, over and above levels associated with a 'normal' energy/commodity market. A big driver of carbon price volatility is market perceptions of scarcity, so regulatory 'tinkerings' with the supply-demand balance will have major follow-on impacts. As a case in point, there was high volatility in Phase 1 of the EU ETS, with allowance prices falling some 60 percent in one day as the result of premature release of verified emissions data, leading to a shift in perception from a net-short to net-long market. From a purely quantitative point of view, there is some debate over how representative the last three years of EU ETS Allowance prices behavior will be of future volatility levels. Cynics will expect more of the same, as both governments and liable companies bed down to operate in a Carbon-constrained world. Thus one can expect risk managers to supplement their tradition risk modeling and quantification techniques with a healthy dose of stress-testing, based on real-world scenarios."

Balance is Necessary for Success
As noted by Dr. Earthey, for any cap and trade scheme to be successful, both commercially and in terms of reducing emissions, the market must have a perception of "scarcity"; that is, caps must reflect real reductions in emissions, and by implication, a real cost in meeting the cap requirements, otherwise, the certificates, as it emerged in Europe, will decline in value and risk market collapse. However, if the cap is too aggressive and reflects required reductions beyond what is commercially and/or technically achievable, prices for certificates will skyrocket, which will be quickly reflected in ever increasing prices for goods and services across the board for consumers.
That's the delicate balance that must be struck—CO2 reductions must be real, but achievable without serious economic damage. While a cap and trade system is the most effective system for allocating costs from the most efficient entities to the least efficient, on a macro level, such a system cannot reduce the real costs of reducing greenhouse gas emissions, it will merely provide an efficient method to redistribute them.

Ultimately, the success of any carbon reduction program will be dependent upon the regulators ability to recognize what is achievable within a framework similar to that elaborated by the ten Senators. If a program of carbon reduction is based on projections of continual advancements in enabling technologies that fail to materialize, the ultimate costs of such a program could be much greater than anyone, other the most cynical, anticipates.
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1 In 2003 Dr. Mark Earthey became MD of LoigicaCMG's "Emissions Solutions Business". In this capacity, he joined the British Government Department of Trade and Industry "Emissions Roadshow" team that exports UK knowledge on emissions trading and environmental compliance. Mark continues in this role at the Lacima Group and often speaks at conferences and workshops across the world dedicated to Carbon trading and the cap and trade mechanism. Mark frequently mixes with the whole community of participants in emissions trading schemes, including politicians, company executives, risk managers, traders, and IT managers, seeking their views and discussing their concerns. He is a well-known commentator on environmental matters.